1. CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
A.S.Akat
EC101- Chapter 7
PART THREE
SUPPLY AND DEMAND – II MARKETS AND WELFARE
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
Chapter 7 1 1

2. A.S.Akat
EC101- Chapter 7
What did we learn so far?
Part One introduced us to some basic concepts as well as tools of economics as a science
Ten principles (Ch.1)
Thinking like an economist (Ch.2)
Exchange and trade (Ch.3)
Part Two introduced us to markets and how they work through the forces of supply and demand
Supply and Demand (Ch.4)
Elasticities (Ch.5)
Markets and government policies (Ch.6)
Part Three looks on the welfare implications of the market system

3. What do we learn in this part?
A.S.Akat
EC101- Chapter 7
What do we learn in this part?
We search for an answer to the following question
Are markets a good way to organise the social process of production?
To answer it we develop the concepts of consumer surplus, producer surplus and total surplus
They allow us to explain market efficiency
We then apply our new tools to understand the costs of taxation and the benefits of international trade
Part Three is made of
Ch.7 : Consumers, producers and market efficiency
Ch.8 : Application: Costs of taxation
Ch.9 : Application: International trade

4. Market equilibrium revisited
A.S.Akat
EC101- Chapter 7
Market equilibrium revisited
Market equilibrium reflects the way markets allocate scarce resources
Supply and demand determines the equilibrium price and quantity for each good
Thus the resources that goes into its production as well as who shall benefit from its consumption
The next question is to find out if the equilibrium price and quantity maximize the total welfare of buyers and sellers?
Welfare economics answers this question
And determines whether the market allocation is desirable or not from the perspective of society 3 2

5. A.S.Akat
EC101- Chapter 7
Welfare economics
Welfare economics study how the allocation of resources affects economic well-being in society
It uses a new concept called “surplus”
And shows that buyers and sellers both receive benefits from taking part in the market
Therefore the equilibrium in a market maximizes the total welfare of buyers and sellers
Consumer surplus measures economic welfare from the buyer side
Producer surplus measures economic welfare from the seller side
Together they allow us to evaluate the allocation of scarce resources by markets 4 3

6. A.S.Akat
EC101- Chapter 7
Willingness to pay
Willingness to pay is the maximum price that a buyer is willing and able to pay for a good or service
It corresponds to the value attributed by the buyer to the good or service demanded
The willingness to pay cannot always be directly measured in the market but it is still there
How much a buyer will be willing to pay for a good or service is the maximum price at which he/she will purchase that good or service
What determines the maximum price?
The benefits that the buyer expect to receive from the consumption of that good or service 9 6

7. A.S.Akat
EC101- Chapter 7
Consumer surplus
Consumer surplus is the key concept of welfare economics
The market demand curve shows the various quantities that buyers would be willing and able to purchase at different prices
As the price goes down, the quantity bought goes up
Consumer surplus is the difference between the willingness to pay for the good or service and the actual spending for it
Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it 6 8

8. Willingness to pay with four possible buyers
A.S.Akat
EC101- Chapter 7
Willingness to pay with four possible buyers 11 10

9. Willingness to pay with four possible buyers
A.S.Akat
EC101- Chapter 7
Willingness to pay with four possible buyers 11 11

10. Measuring consumer surplus with the demand curve
A.S.Akat
EC101- Chapter 7
Measuring consumer surplus with the demand curve
Price of
Album
$100
John’s consumer surplus ($30) 80
Paul’s consumer surplus ($10) 70
Total
consumer
surplus ($40) 50
Demand 1 2 3 4
Quantity of
Albums 13 18

11. Consumer surplus, demand and price
A.S.Akat
EC101- Chapter 7
Consumer surplus, demand and price
Consumer surplus is the area that lies below the demand curve and above the market price
Consumer surplus depends on the demand curve, which represents the willingness to pay
And the market price which represents market equilibrium
Ceteris paribus, changes in price and demand affect consumer surplus
Lower market price increases consumer surplus
Higher market price reduces consumer surplus
Higher demand increases consumer surplus
Lower demand reduces consumer surplus 15 19

12. How the price affects consumer surplus
Initial
consumer
surplus C
Consumer surplus P1 B
to new consumers F P2 D E
Additional
consumer
surplus to
initial
Demand
consumers Q1 Q2
Quantity 17 28

13. A.S.Akat
EC101- Chapter 7
Willingness to sell
We can now apply the concept of surplus to the producers
Market supply curve shows the various quantities that producers would be willing and able to sell at different prices
It may be seen as a measure of supplier costs, that is, the opportunity cost of supplying various quantities of the good.
The marginal opportunity cost of production increases as market output expands
Because a producer’s cost is the lowest price he/she will accept, cost is a measure of his/her willingness to sell 22 32

14. A.S.Akat
EC101- Chapter 7
Producer surplus
Producer surplus is the symetric image of consumer surplus on the supply curve
It is measured by the difference between the willingness to sell of the producers for a good or service and the actual revenue they receive from it
Producer surplus is therefore the amount a seller is paid minus the cost of production of the good or service
It is the area that lies above the supply curve and below the price line
Producer surplus measures the benefit to sellers of participating in a market 24 34

15. The costs of four possible sellers
A.S.Akat
EC101- Chapter 7
The costs of four possible sellers 11 35

16. Supply schedule with four possible sellers
A.S.Akat
EC101- Chapter 7
Supply schedule with four possible sellers 11 36

17. Measuring producer surplus with the supply curve
A.S.Akat
EC101- Chapter 7
Measuring producer surplus with the supply curve
Price of
House
Painting
Supply
Total
producer
surplus ($500)
$900
800
Georgia’s producer
surplus ($200)
600
500
Grandma’s producer
surplus ($300) 1 2 3
Quantity of
Houses Painted 26 43

18. How price affects producer surplus
A.S.Akat
EC101- Chapter 7
How price affects producer surplus
Price
Additional producer
surplus to initial
producers
Supply D E P2 F B P1 C
Initial
producer
surplus
Producer surplus
to new producers A Q1 Q2
Quantity 26 52

19. A.S.Akat
EC101- Chapter 7
Market efficiency
The sum of consumer surplus and producer surplus is a good measure of the well-being of society
A market with perfect competition and without externatilities maximises society’s well-being
Consumer surplus = value to buyers – amount paid by buyers
Produces surplus = amount received by sellers – cost to sellers
Total surplus = value to buyers – cost to sellers
Market efficiency is attained when the allocation of resources maximizes total surplus
Competitive markets are therefore efficient 32 53

20. Efficiency versus equity
A.S.Akat
EC101- Chapter 7
Efficiency versus equity
It is very important to understand the limitations of the word “efficiency”
In an efficient solution, nobody can be better off without someone else becoming worse off
If it possible to increase one person’s well-being without reducing that of the others the solution is clearly inefficient
But efficiency does not mean equity nor equality
Our sense of fairness may not be satisfied with an efficient situation which corresponds to a very unequal distribution of well-being among members of society
Equity is also very important for society 32 53

21. Consumer and producer surplus in the market equilibrium
A.S.Akat
EC101- Chapter 7
Consumer and producer surplus in the market equilibrium
Price
Equilibrium
price
Quantity
quantity A
Supply C B
Demand D
Producer
surplus
Consumer E 33 58

22. Efficiency of equilibrium
A.S.Akat
EC101- Chapter 7
Efficiency of equilibrium
Quantity
Price
Equilibrium
quantity
Supply
Demand
Cost to
sellers
Value
buyers
Value to buyers is greater
than cost to sellers.
Value to buyers is less

23. Market efficiency: three observations
A.S.Akat
EC101- Chapter 7
Market efficiency: three observations
Welfare economics allow us to evaluate the meaning and benefits of a market economy for the society
We highlight three aspects that makes the market economy desirable for society
Free and competitive markets allocate the supply of goods to the buyers who value them most highly
Free and competitive markets allocate the demand for goods to the sellers who can produce them at least cost
Free and competitive markets produce the quantity of goods that maximizes the sum of consumer and producer surplus 35 59

24. Market as an “invisible hand”
A.S.Akat
EC101- Chapter 7
Market as an “invisible hand”
In a free market there is no centralised social authority to allocate scarce resources
The many buyers and sellers in a market economy are motivated by self-interest, not by altruism
A process of coordination and communication takes place so that buyers and sellers are directed to the most efficient outcome
As if by an invisible hand, the free market system reaches efficiency
Scottish economist Adam Smith first coined the term “invisible hand” in his book The Wealth of Nations, published in 1776 36 62

25. Tickets on the sidewalk
A.S.Akat
EC101- Chapter 7
Tickets on the sidewalk
Let us look at an interesting example
Assume you decide to go to a show or a football game at the last minute?
Your only chance is to go to the theater or the stadium with the hope that someone will be selling tickets
But you have to pay a higher price
Is it “black market”? Or is it a service?
For the economist the enterpreneurs who buy tickets in advance to sell them with profit at the door take risks which explain their profits
The economist will be worried about whether they pay or not income tax on this income

26. Market failure: market power and externalities
A.S.Akat
EC101- Chapter 7
Market failure: market power and externalities
Market power is the ability of one buyer or seller to control market price
Market power reduces total surplus
It is called market failure because it causes markets to be inefficient
Externalities are the benefits or costs imposed on a third party who is not the consumer or the producer
Such as the cost of pollution to the society which is not included in the price of the good
Externalities result in lower total surplus
Causing markets to be inefficient, and thus fail 38 67

27. A.S.Akat
EC101- Chapter 7
Conclusion
Welfare economics evaluate the market from the perspective of society
Consumer and producer surplus measures the benefits of buyers and sellers from participating in the market
An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient
Policymakers are concerned with efficiency and also equity
Market power and externalities can cause markets to be inefficient and to fail